A macro-econometric model for the economy of Lesotho [ Article 2010110301 - 03/11/2010]

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The Federal Planning Bureau took part, in collaboration with the German institute DIW Berlin, in a technical assistance project financed by the European Commission aimed at developing different modelling approaches for the economy of Lesotho, a small country landlocked within the territory of South Africa. In the context of this project a macro-econometric model was elaborated. This Working Paper describes the main characteristics and the behavioural equations of this model and discusses a baseline simulation and an alternative scenario aimed at reducing up to 2012 the expected public deficit.

As a single model is not capable of adequately capturing, modelling and processing all the information required by policy-makers, the philosophy of the project was to develop complementary tools that can be used for different applications. Accordingly, a Financial Programming Framework and a CGE model were elaborated by other partners in the project. The strategy behind the development of the macro-econometric model relies on its complementarities with the Financial Programming Framework, which is an integrated system of spreadsheets.

The economy of Lesotho has gone through a number of major structural changes over the past twenty years. Firstly, the Lesotho Highlands Water Project (LHWP) pushed up infrastructure investment in the nineties with the building of two dams to transfer water to South Africa. Secondly, export-oriented industries emerged over the last decade due to the opening of several diamond mines and the implementation of the US African Growth and Opportunity Act offering duty and quota- free access to the US market. While benefiting from these positive shocks, Lesotho is also facing a continuous decline in net primary incomes from abroad as the number of citizens working in South Africa is gradually decreasing. Finally, as a member of the Southern African Customs Union (SACU), Lesotho receives its share of the revenue pool of custom duties. As this is the main source of income for the government (SACU revenues amounted to around 50% of government revenues over the last ten years), their evolution has an important influence on economic growth through public spending.

Due to the important influence of these supply-side shocks, the Lesotho economy does not satisfy the traditional view that aggregate demand is the main determinant of growth in the short run. These shocks also impede the identification of stable long-term relationships over the available sample. Therefore, the behavioural equations do not rely on error correction mechanisms, but on simple linear specifications estimated in growth rates. Variables reflecting the shocks (exports, investment related to the LHWP, net primary incomes from abroad and SACU revenues) are exogenous in the model.

The macro-econometric model contains about 130 equations that can be split up into 15 behavioural equations, 70 accounting identities and 45 “technical” equations. Expenditure components of GDP are determined by their traditional explanatory variables (private consumption by disposable income of households, private investment by value added, etc.). To ensure compatibility with the Financial Programming Framework, the main industries in Lesotho are also modelled. Traditionally, industries are linked to expenditures through an input- output table, but as this is not available for the economy of Lesotho, stochastic relationships between value added of an industry and the relevant components of final demand are estimated. Export-oriented industries are linked to their respective export categories, while value added of industries oriented towards the domestic market depends on consumption and investment. To ensure consistency between supply and demand, it is assumed that any excess demand is satisfied by imports, implying that imports are calculated as a residual.

As information on price-setting behaviour and sufficiently detailed series on wage and non-wage costs in Lesotho are currently not available, the price block is quite rudimentary. Although most deflators depend on price developments in South Africa, the deflator of services acts as a tension indicator as it is positively correlated to the growth of value added.

The modelling approach of the income side of the economy reconciles existing data limitations and the need to allow second-round effects to play a role in the model. Employment data are not available in the national accounts of Lesotho, so primary incomes cannot be modelled bottom-up. As a rule of thumb, the share of wages and mixed income in value added of the industries in the model is assumed to remain constant in projection. Tax revenues are assumed to develop in line with their macroeconomic taxable bases.